Banks will soon need to consider climate risk when lending: APRA

For the first time this year, the plan includes APRA’s policy and supervision priorities, as well as a new inclusion of data priorities.

The document revealed that the regulator will be lifting standards and undertaking a series of tests to manage risk in the Australian financial system, including climate risk, cyber risk, and the ‘interconnectedness’ of the financial system.

Among the changes will be a move to bolster against climate and nature risks, given that regulated entities are exposed to risks associated with the increased frequency and severity of climate-related events, which can impact the value of certain assets, income streams, and underwriting risks.

APRA said that there is also a “heightened global focus of the impact of nature-related risks, such as the loss of biodiversity on the financial system and the community”.

Given the risk posed by climate changes, APRA has said it will be gradually increasing expectations for regulated entities (including the 138 banks that have $2.2 trillion of mortgages on their books) to consider climate-related risk in financial decisions and “aligning them with emerging best practice globally”. This will include lending, underwriting, and investing.

It will also be increasing industry and supervisory awareness of the impact of nature risk on the resilience of entities, the financial system, and the community, as well as continuing to support the government’s sustainable finance agenda.

To achieve this, its key regulatory activities will include incorporating climate risk in the prudential framework by consulting on amendments to include climate risk.

APRA said it would also be seeking to understand the impact of climate change on household insurance affordability.

To do this, it will be undertaking a Climate Vulnerability Assessment (CVA) to develop an understanding of climate risk drivers of insurance affordability challenges across the five largest household insurers (covering approximately 80 per cent of the household insurance market) out to 2050.

Australia’s first system test to understand ‘interconnectedness’

As well as climate risk, APRA’s corporate plan revealed that the regulator would develop Australia’s “first system stress test to better understand interconnections across the financial system”.

The test comes after the financial system chaos caused by the collapse of Silicon Valley Bank in the US, which had a ripple effect across many developed markets and “heightened geopolitical tensions”, which may result in unexpected shocks to financial stability and asset values.

While APRA conducted a stress test of 10 “systemically important” Australian banks amid concerns over the stability of the global financial system last year (which found that Australia’s largest banks would withstand a major financial crisis), it will soon undertake a system stress test to understand risk transmission mechanisms between regulated industries and across the financial system.

The system stress test includes tier 1 banks (although specific entities are to be determined) that will involve a design phase in the first half of the financial year 2024–25 and commence in the second half of FY24–25 (with this including a data collection).

It is hoped this would provide a platform to quantify, assess, and respond to identified risks (including understanding the impact of geopolitical risk on the financial system) and ensure regulated entities can withstand “a severe but plausible stress event, operate effectively in a crisis, and that the financial interests of beneficiaries are protected”.

In the same vein, APRA has said it will partner with the Council of Financial Regulators and New Zealand agencies to test APRA’s ability to respond to severe unexpected events, via a crisis simulation.

Payments system may fall under APRA

APRA went on to note that more entities “with non-traditional business models” are approaching APRA to be prudentially regulated and that the government is proposing to expand APRA’s regulatory responsibilities into payments.

As such, the regulator will partner with the Council of Financial Regulators to look at the design of a new legislative framework for payments licensing and, subject to proposed payments licensing legislation being drafted and passed by Parliament, consulting on new prudential standards.

APRA chair John Lonsdale said the plan aimed to ensure the continued financial and operational resilience of APRA-regulated entities, while also responding to new and heightened risks.

“At a time of considerable geopolitical volatility and with an uncertain economic outlook, it’s vital that banks, insurers and superannuation trustees are prepared for whatever potential challenges could arise,” he said.

“Over the coming four years, APRA will step up its focus on operational and cyber-resilience to ensure our regulated entities are equipped to maintain critical financial services in a world that is becoming more interconnected and dependent on digital technologies. We will delve more deeply into that interconnection by examining the links between banking and superannuation and the possible contagion risks that arise from that relationship.

“On the policy front, having spent more than a decade building up the strength of the prudential framework, APRA is now in a position to focus on maintaining that strength. While we plan to have a broad approach focused on adjusting or recalibrating existing settings, there are exceptions, including reform of our prudential standards on governance over the next 12 months.

“In supervision, we will retain a close watch on risk culture and risk management, with climate change and crisis preparedness to be areas of particular focus over the next year. As always, we will back up our approach with a strong appetite for taking enforcement action where required to ensure that entities comply with the law and the community is protected.”

[Related: New Senate inquiry to delve into home lending]